Is social networking while investing bad for your wallet?

NEW YORK Wed Nov 16, 2011 10:03am EST

A dealer talks to an online client at DLJdirect SFG Securities in Tokyo September 24. Many online ventures are gearing up for a pricing battle in the world's second-largest economy, where the growing popularity of the Internet is boosting online trading by individuals who previously had little experience investing in stocks.TA/CC

A dealer talks to an online client at DLJdirect SFG Securities in Tokyo September 24. Many online ventures are gearing up for a pricing battle in the world's second-largest economy, where the growing popularity of the Internet is boosting online trading by individuals who previously had little experience investing in stocks.TA/CC

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NEW YORK (Reuters) - If you judge the value of the financial advice you get by the amount you pay for it, then free investment message boards have to be risky. Yet websites from the venerable fool.com to a myriad of startups with names like tradeking.com, didyouinvest.com and firsttrade.com abound for people to convene online around virtual water coolers and share stock tips, buying and selling strategies and market commentaries.

Two recent studies argue that this either leads to risky behavior, or is a path to success. But both agree that financial information is difficult to glean from social networks and that day traders need to be careful where they get their financial tips.

"There is good information and there is junk information," says Yaniv Altshuler, who has been studying the social network trading site eToro.com for much of the last year. "The key is figuring out how to predict what kinds of networks allow the junk information to be filtered out."

Research from Houston's Rice University finds that financial decisions made via online social networks can lead to particularly foolhardy behavior. Released in September, the study "Does Online Community Participation Foster Risky Financial Behavior?" (see link.reuters.com/wuv94s) observes the financial decisions of eBay and prosper.com users and concludes: "Online community participation leads to greater risk seeking financial decisions. Participants of online communities lent their own money to riskier borrowers to a greater extent, when compared to community non-participants."

But Altshuler, a post-doctoral associate at MIT's Human Dynamics Group, says he has found that risky online behavior isn't necessarily bad for a trader's bottom line.

eToro has a Twitter-like feature that lets users follow peer trading, copy decisions if the impulse strikes and communicate with peers about why they've invested as they have. Public on each user's profile are recent trades captured in real time and success rates.

Altshuler agrees with the conclusion in the Rice study that the problem with open social networks is the inconsistent quality of distributed information and the inability to see the financial successes and failures of other users. His data shows, however, that when users have access to social networks that provide success rates and other actionable information, they can make twice as much as when they merely discuss trades on open social networks.

Santosh Tiwari, 36, an eToro user and software consultant based in the U.K., backs this up: It's true that "new traders are more susceptible to 'noise' in market, which is an integral part of social networks," he writes in an email to Reuters. "But that noise can be -- weeded out when you bring in performance stats of the people who are participating in networks."

Tiwari didn't start trading until the crash of 2008. The market was volatile and he was able to reap some moderate successes. He and his wife began trading together. In their first two months of investing, they experienced 1,600 percent growth in actual returns, which lead them to experiment with social networks and more traditional trading avenues.

They now operate their eToro account as an "alternate profession," he says. They've had ups and downs, but after more than three years they've experienced an average of 100 percent growth in actual returns yearly. He still considers himself a "new trader" and sticks with eToro because it's easy to use and gives him concrete statistics on which to base his decisions.

"There are patterns which you can see in the trading activity," he writes. "It does give you a good insight on how the market may be reacting to a situation."

Still, who's to say those stats and trending activities aren't manipulated in some way? Dr. John R. Birge, a professor of operations management at the University of Chicago's Booth School of Business, responds by referencing a 1993 Peter Steiner New Yorker cartoon in which two dogs sit at a computer and the caption reads, "On the Internet, nobody knows you're a dog."

Stats or no, Robert Korajczyk, a professor of finance at Northwestern's Kellogg School of Management, says any site that encourages individuals to trade frequently is likely bad for their bottom line.

"The evidence is conclusive that retail investors that trade a lot don't make much money," Korajczyk says. "If social networking environments get to you to trade a lot, you're making a mistake."

He continues: "People who don't for a living tend to lose money. So I would encourage people to buy a well-diversified mutual fund and forget the day trading."

The Rice study's author, Dr. Utpal M. Dholakia, a professor of management at Rice University, says social networks can lull users into a sense of comfort that may not be optimal for making important financial decisions. Online communities can be used to educate users but often that education isn't backed up by anything but a consensus from a relatively small number of people, he says. Resulting behavior usually goes one of two ways: People become more risk averse or they make riskier decisions.

Dholakia's study finds that often people are more inclined toward the latter.

"People often forget that what they do online is not necessarily what goes on in the real world," Dholakia says.

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The author is a Reuters contributor. The opinions expressed are his own.

(Editing by Lauren Young and Beth Gladstone)

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